The system-wide effects of bank capital regulation on credit supply and risk-taking∗

We propose a tractable framework to examine the system-wide effects of bank capital requirements. In our model, banks can serve a socially beneficial role by financing firms that are credit rationed by public markets, but banks’ access to deposit insurance (or implicit guarantees) creates socially undesirable risk-shifting incentives. Equity ratio requirements reduce banks’ risk-taking incentives, but may also constrain banks’ balance sheets. When bank capital is not scarce, increases in equity-ratio requirements unambiguously improve welfare and the stability of the banking system. However, when bank capital is scarce, increased equity-ratio requirements induce credit rationing of both bank-dependent firms with positive NPV projects and risky firms with negative NPV. In this case, the net effects on welfare and the risk-taking of banks are ambiguous, as they depend on which type of credit rationing dominates. Our model provides conceptual guidance on the cyclicality of optimum capital requirements as well as their dependence on the development of public markets, the cross-sectional distribution of firms, and the quality of risk signals available to regulators. PRELIMINARY AND INCOMPLETE ∗We are grateful to Anat Admati, Michael Brennan, Elena Carletti, Sam Lee, George Pennachi, Giorgia Piacentino, Matt Spiegel and Jeremy Stein for discussions of earlier drafts of this paper as well as Peter DeMarzo, Nicolae Gârleanu, Valerie Shen, and Ivo Welch for helpful comments. In addition, we thank seminar participants at the Berkeley-Stanford joint seminar, Bocconi, INSEAD, London School of Economics, Stockholm School of Economics, UC San Diego, University of Chicago, University of Northern Carolina at Chapel Hill, the Bundesbank Frankfurt, the Federal Reserve Bank of New York, the Federal Reserve Board of Governors and feedback from the following conferences: NBER SI credit ratings 2013, FIRS 2014, NBER SI corporate finance 2014, WFA 2014, Barcelona GSE summer symposium 2015, Econometric Society World Meeting 2015. †University of Chicago, Booth School of Business, e-mail: [email protected]. ‡University of Pennsylvania, The Wharton School, e-mail: [email protected]. §University of California, Berkeley (Haas), e-mail: [email protected].